Rhys Williams, Chief Strategist, Spouting Rock Asset Management
January 5, 2023
Happy New Year… or should we say good riddance to 2022. After more than a decade of government authorities, both fiscal and monetary, usually helping markets in times of stress, 2022 was different. Last New Year’s Eve, the Federal Reserve (Fed) was expected to raise interest rates 25 basis points twice in 2022 to 50 basis points. They added stimulus by buying mortgage bonds, keeping low rates even lower through the first quarter of 2022. Central bankers were very focused on the Omicron variant circulating the globe last December and the potential downside to US and global growth it might cause.
Fast forward to today: the Fed governors’ are convinced that short rates need to travel from the current 4.5% to 5.25 – 7.0%, depending upon each governor’s degree of hawkishness, and then keep them there for two years. These are the famous dot plots that have captivated markets ever since last March.
Whenever the market gets too concerned about dot plots, a measure of where Fed governors believe interest rates will be over the next three years, remember. . . they have no idea. Their best guess is just a snapshot in time. They see through the rearview mirror clearer than they see through the windshield. The Fed raised rates six times in 2022; four by 75 basis points. This was the fastest tightening in US history, eclipsing even the arch-inflation fighter Paul Volker, a literal giant of a man, who most of the world’s central bankers have now developed a man crush on.
Central bankers are like the rest of us: creatures of history who learned lessons and are much better at fighting the last war than preparing for the next one. Of course, the Fed couldn’t have known last year that Putin would decide that he was done talking about the Donbas and launch the largest land war in Europe since World War II ultimately impacting all things inflation. They also couldn’t have anticipated that Ukraine would exceed even President Zelenskyy’s expectations militarily and force the whole world to take sides, so far more economically than militarily. But just as Archduke Franz Ferdinand’s assassination was an unexpected and unlikely catalyst for World War I, so is the heroism of actor-turned-president Volodymyr Zelenskyy who changed the international order with a very united Europe teaming up with the US and developed Asia, against the BRIC (Brazil, Russia, India, and China) countries and most of the third world. In the 1990s, writer Thomas Friedman penned the book The World Is Flat, arguing that global growth and cooperation would lead to a “more flat” world, with elites in all countries sharing ideals terrific for stock markets and inflation-free revenue growth. Now, this promise has been flattened, with longer-term implications for global growth. While companies continue to work hard to maximize the efficiency of their supply chains, re-shoring is not nearly as margin accretive as off-shoring. The gains from trade between the US and China over the last 40 years have been amazing and a big part of global prosperity since the 1990s. It will be difficult to replace that boost to the world economy as we move from cooperation to coopetition.
In any event, given the massive policy shift from aggressive easing policies to aggressive tightening policies, it is no surprise that the market took no prisoners in 2022. Equities and bonds of all stripes were taken out and slaughtered. But now, we welcome in 2023. The good news is valuations are much different. At the beginning of 2022, Wall Street analysts predicted that S&P 500 Index earnings for the fiscal year 2022 would be about $221 per share. And guess what: for the first time in 30 years, Wall Street got it right. While tech earnings performed worse than expected, industrial and energy earnings performed better. The obliteration of equity and debt markets was not because of massive profit shortfalls, but due to much higher rates and increased fear of the future.
Now CEOs are more concerned about what could go wrong and less worried about missing the upside. Investors are bearish and expecting more bad news, holding copious cash. The pied piper of crypto, Sam Bankman-Fried, morphed from King Midas into Bernie Madoff. Elon Musk has transformed from invincible genius to the Wizard of Oz, representative of the shellacking that all change-the-world companies and their visionary CEOs took. Investor ebullience has become despondence, almost always a good backdrop for new money investments.
While all this valuation resetting was very painful in public markets, we believe they now offer relatively good value compared to private markets. We think that the Fed should finish raising rates in the first quarter and then perhaps a discount rate can be determined for companies’ cashflows, putting a more meaningful bid behind public equity and debt. Given the very delayed resetting of private market assets, we expect 2023 to be the year public debt and equity outperforms private debt and equity. Look no further than the BREIT, a private REIT that invests in industrial and apartment real estate, arguably the most favored in the real estate sector. It appreciated reportedly 10% in 2022 as the underlying assets performed well. Meanwhile, a group of publicly traded industrial and apartment REITs lost 25% or more. Those assets also performed very well. What was different? The public REITs had a huge valuation reset thanks to the Fed raising rates and fears about an eventual recession. The private appraisals are slower to reprice on the downside. Interestingly, the BREIT investors have figured out this arbitrage and are trying to redeem it, forcing Blackstone to gate redemptions rather than sell illiquid assets quickly into a nervous market. This is completely reasonable for Blackstone, which doesn’t want to hurt remaining investors to the benefit of departing investors. But the illiquidity in private markets, which has had a 15-year party since the great financial crisis of 2008, may come back to earth in 2023. For the last decade, bear markets were always short and sweet and then the Fed came to investors’ rescue by lowering rates with an added dollop of quantitative easing. That is unlikely to be the case in 2023. The lack of volatility with great returns that private market asset managers have stacked up has been like mother’s milk to investment committees, as their private investments didn’t experience public market gyrations. Mr. Market appraises public markets every day; private markets appraise much slower. As we enter 2023, public markets are simply more de-risked than private markets. We think public markets tend to outperform in both bullish and bearish market scenarios.
As we position in public markets, we do expect the defensive sectors to outperform until investors become convinced that the Fed is close to finished increasing rates. But we see the kind of shellacking that stock and bond investors experienced in 2022 as unlikely to repeat in 2023, no matter what the Fed does. The Fed controls the short end of the yield curve, but can’t control the long end. Paradoxically, the more aggressively the Fed raises short-term rates, the more likely the 10-year yield declines as investors position for recession. Since equities take their discount rate more from the 10-year yield than short-term rates, it is possible that multiples expand if the Fed overdoes it.
But until the Fed becomes less hawkish, we expect healthcare, defense, some REITs, staples and other recession-resistant stocks to outperform. We also expect energy to enjoy another year of relative success, given the demand boost from China’s emergence from a 3-year Covid hibernation. Dividends and dividend growth will stay at the forefront of investors’ minds to compete with money market funds.
Some industries should have the wind at their backs in 2023 and should outperform. Defense stocks will have another year to mint money as a supplier of weapons to Ukraine and defense spending globally will ratchet higher as every country feels the need to make themselves a difficult target for their neighbors to attack. Restaurants should benefit from more abundant labor as well as cheaper food and transportation costs, thus expanding gross margins. We expect unemployment to rise slowly thanks to the large deficit of US workers. The first few million workers shed will find another job easily. Thus, we expect demand for restaurants to stay strong, especially for double-income, time-starved families.
We know many readers own the big FAMANG stocks: Facebook (Meta), Apple, Microsoft, Amazon, Netflix and Google (Alphabet). They all face problems and none did well in 2022, underperforming even though balance sheets are rock solid and their businesses were historically considered more recession-resistant. It is possible that they have grown so big that even the greatest companies in the history of capitalism can’t keep outperforming, given their size. While we think the days of 20% revenue growth is mathematically difficult to sustain given the base, these companies have never thought about costs. They really have a tremendous opportunity to control their own destinies by cost-cutting. All waste billions on science projects, some of which no doubt will pay off, but none have been forced to compete for capital. By comparison, energy companies have high-graded wells due to numerous ups and downs in this very cyclical industry. Bankruptcy is a tough teacher. Conversely, ever since the dot-com implosion in the year 2000, big tech has printed money from the money tree, given the amazing business moats they have pioneered. For years, they paid up to keep talent as venture and private equity-funded startups. FAMANG all faced demanding workforces, who told the CEOs publicly what kinds of companies they should be doing business with. Now, many in Silicon Valley will be delighted simply to have a job as competitors shut down. There will be a lot less high maintenance of human capital. Since people are these companies’ biggest costs, this diminished workforce negotiating leverage could be a significant windfall for any willing to seize the moment. So far, none have publicly stated that they are going to get aggressive in cost-cutting, but we will be listening closely for this in fourth quarter calls. There is so much fat in most of these companies that it is hard to see the bone.
Just as investors were over-confident last year, they are probably too cautious now. We think public markets – both equity and debt – have given some good opportunities. We expect first quarter earnings to be very difficult, but believe that those investors who are willing to leg into disappointing guidance will likely probably be rewarded. As Warren Buffett points out, investors should be greedy when others are fearful, and fearful when others are greedy. Not much greed right now.
Wishing everyone a happy and prosperous 2023.
The views expressed are those of Spouting Rock Asset Management platform, as of January 1, 2023, and are not intended as investment advice or recommendation. For informational purposes only. Investments are subject to market risk, including the loss of principal. Past performance does not guarantee future results. There can be no assurances that any of the trends described will continue or will not reverse. Past events and trends do not imply, predict, or guarantee, and are not necessarily indicative of future events or results. Investors cannot invest directly in an index.